Fed missed chance to curb dividends, say ex-supervisors

Instead, changes to stress capital buffer and TLAC rules would allow larger payouts

Former supervisors say US prudential regulators have missed an opportunity to follow their European counterparts and ensure banks have more capital to deploy during the Covid-19 crisis by curbing dividend payments.

Instead, the US Federal Reserve passed an interim final rule on March 17 amending the new stress capital buffer (SCB), which will potentially increase the size of dividends banks can pay in the future. Sheila Bair, former chair of the Federal Deposit Insurance Corporation, tells Risk.net that this move is “very disconcerting”.

“If the Fed had done nothing, there would have been automatic limitations on these big banks paying dividends and discretionary bonuses. Instead, they affirmatively took action to delay the impact of those pre-existing restraints,” says Bair, who is now a founding member of the Systemic Risk Council of former prudential regulators.

The SCB sits on top of banks’ risk-based capital ratios. It consists of a floor at 2.5% of tier one capital, with an extra institution-specific component determined by the results of the Fed’s annual Comprehensive Capital Analysis and Review (CCAR). A first draft of the SCB in April 2018 included a sliding scale that would limit dividend payments if a bank’s capital ratio dropped between the upper end of the buffer and the 2.5% floor.

However, the scale used a definition of eligible retained earnings from the previous year that was calculated net of capital paid out to shareholders. Banks objected that this could result in a cliff edge, where healthy firms that had paid out most or all of their net income as dividends in one year would suddenly be unable to pay any dividend the following year.

To rectify this problem, the Fed amended the final version of the SCB, approved on March 4, to change the eligible retained income definition to the average of the preceding four quarters, without deducting capital payouts.

Before the final rule was adopted, a key lobbying objective for banks had been to change the definition further, to include the whole of the retained income for the previous four quarters, rather than just the average. This would potentially allow larger dividend payouts for banks with capital ratios between their individual SCB and the 2.5% floor.

Gregg Gelzinis

The March 17 amendment made exactly this change. On March 23, the Fed followed up with a similar alteration to allow banks to continue paying dividends if they breach their buffers above their minimum total loss-absorbing capacity (TLAC) – which consists of both equity and debt that can be bailed in if the bank fails.

“The original definition embedded incentives for prudent and conservative capital planning, so the banks that weren’t penalised under the old definition were banks that weren’t releasing all of their net income,” says Gregg Gelzinis, a policy analyst at left-leaning think-tank Center for American Progress, who previously worked at the US Treasury.

He adds: “Now is not the time to be enriching shareholders – we should be conserving capital and using that capital to support businesses and households. Also, this change makes it easier for big banks to quickly deplete their capital buffers, which is not good from a safety and soundness standpoint.”

Valuation fears

The Fed justified the March 17 amendment on the basis that it “facilitates the use of firms’ capital buffers to promote lending activity to households and businesses”.

In other words, governors seem to believe that executives will be more willing to deploy their capital buffers to provide additional credit to the economy if they are less concerned that it will result in curbs to future dividend payments.

One bank lobbyist says this stance is correct, because cuts to dividends could be interpreted as a bad sign for the health of the US banking system at a time when share prices are already highly volatile.

“If you’re a bank that announces that no dividends are going to be paid, despite good results from last year, then that can put further pressure on your stock,” says the lobbyist. “Optics are a large part of the story here: banks’ main focus at this stage is demonstrating balance sheet resilience, as well as demonstrating to investors and the market that they have adequate capital and funding.”

This change makes it easier for big banks to quickly deplete their capital buffers, which is not good from a safety and soundness standpoint

Gregg Gelzinis, Center for American Progress

William Lang, a managing director at consultancy Promontory Financial Group and a former supervisor, also agrees with this approach, at least in theory.

“An individual bank doesn’t want to cut its dividends, if people will think it’s a signal that they’re weaker than other banks,” says Lang.

In practice, however, he is concerned about the size of the hit banks may receive from the lockdowns implemented to stop the spread of Covid-19. Despite the breadth, scale and speed of the supportive measures taken by the Fed and Treasury, he even raises the possibility that banks might require a fresh bailout in the event of a particularly deep or prolonged recession.

“This is beyond the kinds of stresses that individual institutions can reasonably be expected to handle,” says Lang. “In a time like this, I think broad-based restrictions on dividend payouts should at least be on the table.”

Retain capital

S&P Global Ratings expects bank earnings to fall nearly 25% compared with 2019, depending on how quickly they can reduce their funding costs, solely based on lower rates, and it expects banks exposed to energy and consumer discretionary to take “an amplified hit to revenues and earnings”.

The European Central Bank and Bank of England have already instructed banks to suspend dividend payments across the whole sector, removing the possible stigma attached to any individual bank that cancels or cuts dividends on its own initiative.

But Sean Campbell, chief economist at the Financial Services Forum, which represents the eight US global systemically important banks (G-Sibs), says there are important differences between the US and European banking sectors.

“In the US, banks have more stringent capital and risk requirements and are generally better capitalised than their European peers.”

Sheila Bair

Photo: Matt Spangler/Washington College

However, Bair is sceptical of such claims, in view of the deep uncertainty surrounding the economic impact of Covid-19, and argues the Fed should have pursued a safety-first approach to dividends, which could always be modified at a later date if the crisis passes quickly enough.

“The immediate shock of this crisis is going to be a lot worse than 2008/2009 and a lot worse than current stress test assumptions, so why take the chance and allow banks not to retain capital? If I'm wrong, they’ll have plenty of money to distribute later and it wouldn’t hurt their balance sheet,” Bair says.

A Boston Fed study conducted in 2010 concluded that, if banks had been required to retain earnings from 2007, they would have retained around half the amount of capital that was subsequently needed as part of the 2008 bailout.

Research by Risk Quantum suggests that US banks could build up their capital by around $27 billion if they cancelled their planned dividend payments for 2020 (see figure below).

 

Analysts emphasise it is very unlikely that any bank plans to use the amendments to the SCB and TLAC rules to raise dividends any time soon. Stuart Plesser, a senior director in the financial institutions team at S&P Global Ratings, says the rule change “does not on its own incentivise [banks] to increase their current dividends”. Instead, he expects their primary focus in terms of capital planning will remain on efforts to avoid “breaching their capital buffer minimum”.

Brian Kleinhanzl, a senior equity analyst at specialist investment bank Keefe, Bruyette & Woods, says increasing dividends at a time like this would be “suicide”. In a worst-case scenario, he expects payouts will remain flat until 2022, or until the third quarter of 2021 in a best-case scenario.

To date, however, JP Morgan has been alone among US G-Sibs in indicating that it would consider halting payouts altogether. Specifically, chief executive Jamie Dimon suggested this could happen in the event of an “extremely adverse” scenario, such as the US economy contracting by 35% or more in the second quarter of 2020.

Editing by Philip Alexander